EIS Benefits for Investors
Philip Hare: For EIS, the investor will get 30% of their investment back, which will come off their income tax liability. They can invest up to a million per year in EIS investments, and that’s two million for knowledge-intensive companies. This can be claimed off the tax liability for that financial year, or it can be carried back to the previous year.
There are other benefits: deferral relief and potential loss relief, which we’ll touch on further later. And then there’s the big one: if the shares are sold at a profit after the three-year holding period, the capital gain is tax free. That’s going to be very beneficial to investors.
SEIS: The Early-Stage Scheme
Philip Hare: SEIS is kind of like the baby brother of EIS. The income tax relief is slightly more generous: that’s 50% of your investment. Investors can invest up to £200,000 in SEIS-eligible companies. The other reliefs are roughly the same, and usually EIS and SEIS shares will qualify for business property relief from inheritance tax as well.
Company Qualification Requirements
Philip Hare: There are requirements for companies to qualify for the schemes. Broadly, the company must be carrying on a qualifying trade, or conducting R&D which will lead to that qualifying trade. It must not be trading in a partnership. It must not be on a recognised stock exchange: AIM is fine. It must have a substantial part of its business in the UK. Overseas companies can qualify, but a substantial part of the top company’s business must be based in the UK from a fixed place of business.
In terms of the shares investors receive, they don’t have to be called ordinary shares, but they have to have certain rights which mean they can’t receive payouts ahead of other share classes. That’s a timing preference rather than an economic preference. They can have an economic preference, but it’s the timing of the payouts rather than the economic preference. The shares must be issued for cash and must be new shares.
SEIS Company Criteria
Philip Hare: SEIS is really for small companies: fewer than 25 employees, no more than £350,000 in gross assets. It must be the first trade the company is carrying on, and the trade must be less than three years old. The company must never have been controlled by another company and must not have raised any EIS or VCT money. It’s for really early-stage companies. Each company can raise up to £250,000 of SEIS funds. If a company is young enough and small enough, it’s always worth seeing whether part of the investment can be SEIS, given the tax reliefs are better.
EIS Company Criteria
Philip Hare: For EIS, it’s slightly larger and later-stage companies: fewer than 250 employees, or 500 for a knowledge-intensive company. It must have no more than £15 million in gross assets immediately before the investment, and no more than £60 million afterwards. The trade must be no more than seven years old, measured from the first commercial sale, or ten years for a knowledge-intensive company.
The age of the company is one of the main reasons why a company doesn’t qualify, so it’s always something we check very early on. People can actually think they are too old, and then when we speak to them, we find out the trade is less than seven or ten years old.
The company must not be controlled by another company and must meet the annual and lifetime limits on state funding. Those limits are £5 million annually and £12 million over the lifetime of the company, or £10 million and £20 million respectively if the company is not knowledge-intensive.
The Advance Assurance Process
Philip Hare: In terms of the process for applying for EIS, the advance assurance is obtained ahead of the investment. We advise on everything leading up to and including those submissions to HMRC. This is not a must-have. It depends on the type of investors and the comfort the company requires before it sees an investment. But it should give investors comfort that, if they do invest in the circumstances set out in the advance assurance application, the company will qualify and they will be eligible for EIS investment.
Compliance Statements and Issuing Certificates
Philip Hare: After the investment is made and the shares are issued, the SEIS1 or EIS1 compliance statement must be submitted to HMRC, which, if approved, will authorise the company to issue the corresponding certificates to each investor for their particular investment, which they then use to claim the relief.
The company must receive the funds before the share issue. The shares must be fully paid up at the time of issue, must be new shares, and must not be transferred shares from another investor. Each investor must not claim the tax relief until they have received their SEIS3 or EIS3 certificate.
The investment can be carried back and the relief claimed in a previous tax year to the share issue. Sometimes that means the investor needs to amend their tax return. The key point is they cannot claim the relief until the certificate is received.
Investor Connection Rules
Philip Hare: The investor must not be connected to the company when they invest. That can mean several things: having more than a 30% stake in the company, for example. Investors must remain at 30% or below. They cannot be an employee of the company, although directors can qualify under certain circumstances.
For SEIS, directors can always qualify. For EIS, directors can invest and receive EIS relief if they are not paid, or if they invest before they became a director or became involved in the trade of the company. In both cases, investors can then make further qualifying investments for three years after the share issue date.
The 30% test takes into account associates and future entitlements. Indirect holdings also need to be aggregated for this purpose.
For EIS only, there is also the independent investor requirement: at the time of investment, the investor must not hold any non-EIS shares in the company, otherwise they will not be eligible for EIS relief on their new shares. Unlike the 30% test, the independent investor requirement does not take into account associates: you only look at your own shareholding.
Common Pitfalls: Upfront Disqualifiers
Philip Hare: These are things we see more often than we ought to. The first is that if shares are issued by the company before it receives payment for those shares, you can’t get relief for that investment. You don’t need to issue the shares on the same day you receive the money. You can collect the money from several people and, once you’ve got it all, issue the shares. The date of the share issue is the date the share register shows the shares being issued. You may have to prove, if HMRC asks, that you had the money in your bank account at that date, or that it was held by an intermediary on behalf of the company.
The second point: SEIS shares must all be issued at least one day before any EIS investment. You can’t issue SEIS and EIS shares on the same day, nor, having made an EIS investment, can the company then receive any SEIS investment, even if it still has SEIS capacity left. Since SEIS reliefs are much more generous, if it’s possible to stagger the investments over two days, investors can get the higher rate of tax relief on the SEIS portion and then EIS for the balance over £250,000.
Employees are not eligible for tax relief under either SEIS or EIS. This applies not just at the time of investment, but also if you subsequently become employed by the company. If you, or one of your associates, becomes employed by the company, that will cause withdrawal of the tax relief.
There is a range of anti-avoidance legislation ensuring that money goes into the company for the long term and is genuinely at risk. There’s a rule called Prearranged Exits, which is quite wide. If there are any arrangements at all for you to dispose of your shares, you don’t qualify upfront. Likewise, if HMRC regards anything as mitigation against the risk of making the investment, such as insurance or a guaranteed income arrangement, that is also a problem. They treat anti-dilution rights as being a protection against risk. It is possible for shares to have anti-dilution rights and still qualify for SEIS or EIS, but investors must carve themselves out irrevocably of those rights.
Common Pitfalls: Post-Investment Issues
Philip Hare: After you’ve claimed your tax relief, several things could cause it to be lost. EIS funds have to be fully employed within two years of the share issue, and that’s an all-or-nothing test. If 90% of the funds are employed and 10% are not, you lose all the relief. SEIS has a three-year period, and the money must actually have left the company.
The shares that carry the tax relief have to remain eligible shares. The most common issue we see is where a company introduces a staff incentive scheme with shares that don’t participate until they reach a hurdle, meaning the ordinary SEIS/EIS shares have a preference over those. There is a way to do it compliantly, but do take advice before making any changes. Similarly, as companies grow and take on Series A or Series B funding with new share classes, that needs to be done in an EIS-compliant way.
If shares are disposed of within the three-year period, you’ll lose the relief, and even a part disposal of those shares can cause loss of relief. Changing share rights during the restricted period can also be regarded as a part disposal. It will generally be possible to flatten a share structure before a flotation, but HMRC agreement that this won’t be treated as a disposal is strongly recommended.
If an investor receives their money back, or part of it, the value received rules apply. One example: if an investor made a loan to the company and that loan is repaid within the three-year period, that can cause loss of EIS relief. Convertible loans that convert into shares are treated as a repayment of the loan. Any other transactions or payments to the investor that aren’t at market value, or not in exchange for services, can also cause loss of relief.
One that people aren’t always aware of: if a company buys back any of its shares during the three-year restricted period, even if not from an EIS investor, that can cause loss of EIS relief. The reasoning is that EIS money is new money going into the company, not replacing other people. There should be no mechanism during that restricted period whereby people effectively exit via a share repurchase.
The company has to continue carrying on a qualifying trade throughout the three-year period. Non-qualifying activities must remain at a very low level. Anything to do with the structure of the company, including share capital, ownership, subsidiaries, or entering into partnerships or joint ventures, can have the effect of losing the tax relief. If the SEIS or EIS company comes under the control of another company, that loses the company’s status. Subsidiaries must remain at least 90% owned.
Loss Relief
Philip Hare: Not every company makes it. One of the benefits of the tax relief is that you can also get relief for losses. You get a loss on your shares when you dispose of them, when you sell, or when the company is dissolved. You can also deem there to be a disposal where you still own the shares but they have come to have no value at all, by making what’s called a negligible value claim, which treats you as selling the shares to yourself for nothing.
To give an example: you put £100 into an EIS company and claim £30 of tax relief, so your net cost is £70. If the company is dissolved or you make a negligible value claim, you have a loss of £70. Normally that would be a capital loss, but you can instead elect to set it against income.
Most people with SEIS or EIS investments will elect under the share loss relief provisions to set the loss against income rather than capital. This is done on your tax return and needs to be claimed in the tax year the loss arises, or you can treat the loss as arising in the previous tax year. You can also split it across two years to maximise relief. Given that income tax rates can reach 45%, or effectively 60% in the £100,000 to £120,000 band where the personal allowance is lost, this is generally more tax-efficient than leaving it as a capital loss. There is a two-year time limit from the relevant 31 January filing date to make the claim.
Q&A: Knowledge-Intensive Companies
Interviewer: Can you elaborate on knowledge-intensive companies?
Philip Hare: For a company to qualify as knowledge-intensive, there’s a numbers test and an activity test. The operating cost condition is that, looking at the last three years for which the company has filed accounts, R&D must represent at least 10% of operating costs in each of those years, or 15% in any one of those years. “Operating costs” means all costs of the company, including cost of sales.
There’s then the innovation condition or the skilled workforce condition. The skilled workforce condition, requiring 20% of employees to hold a master’s degree or higher in their area of work, is rarely used. Usually the company will meet the innovation condition instead, which requires that they are creating intellectual property on which the majority of the business will depend in the next ten years. If you’re spending that much on R&D, it’s reasonable to assume you’re creating IP on which the business will rely.
Both conditions need to be assessed at the time of each investment on an ongoing basis. Companies can cease to be knowledge-intensive as they grow and their cost base shifts. Qualifying as knowledge-intensive gives further flexibility on age and on the amount of investment the company can receive.
Q&A: Share Preferences and EIS Compliance
Interviewer: We have ordinary A shares and several other classes, all starting with the word “ordinary” but with various letters and numbers. They have a basic liquidation preference. We also have ordinary shares with an employee EMI option scheme. Is a simple liquidation preference one that would exclude the relief?
Philip Hare: We’d have to look at the detail. The idea is that EIS shares should not go ahead of other shares on a distribution: it’s about the order. What you can do with a bit of tweaking is structure an economic preference that still works for EIS, by ensuring everybody participates at least a little bit at each stage of the waterfall. That’s very common practice today. Get in touch and we’ll look at the articles.
Q&A: The Seven-Year Rule and Ongoing EIS Eligibility
Interviewer: I’ve heard that once you’ve qualified for EIS within the seven-year window, you can continue to claim even beyond those seven years. Is that correct?
Philip Hare: Yes. The condition you’re referring to is Condition A of the permitted maximum age requirement. Ordinarily, a company must receive the investment within seven years of the first commercial sale. However, if they received EIS investment within that period, they can continue to raise money after that window has closed, as long as it’s for the same business activity as the original investment that was made within the seven-year period. They can continue to qualify outside of the seven or ten-year period, provided the activity is consistent.
Interviewer: What about ASAs where there’s a long-stop date?
Philip Hare: HMRC’s guidance is that they won’t give advance assurance where the long-stop date is more than six months away. We have, however, had companies get tax certificates where the long-stop date was longer. You just won’t get an advance assurance in that case. The EIS investment is treated as being made when the shares are issued, not when you enter into the agreement or send money. So if you’re trying to get a company within the seven-year window and it’s six years old, make sure those shares are issued before the seventh anniversary.
Q&A: Negligible Value Claims and Loss Relief Documentation
Interviewer: What documentation do investors need to support a negligible value claim, and is a portfolio statement showing £0 value sufficient for HMRC?
Philip Hare: The most common scenario is where a company has gone into administration. An administrator’s report stating the chances of a payout are virtually nil can be used as evidence. If it hasn’t got that far, a statement from the investment manager can work. It depends on what it says and whether there is any residual hope value. If you can credibly state there will be no payout, investors should be able to rely on that. If the company has actually been dissolved, you don’t need a negligible value claim at all: you simply report the disposal on your tax return and claim the resulting loss. You only have two years, measured from the relevant 31 January filing date, to elect for that loss to be set against income rather than treated as a capital loss.
If you make a negligible value claim and the shares subsequently increase in value, you cannot withdraw the claim. Any future growth from that zero value upwards will be subject to capital gains tax.
Q&A: Fully Paid Shares and Fractional Share Prices
Cam Ross: When share prices run to six decimal places, are we right to always round up to the nearest penny to ensure shares are fully paid?
Philip Hare: A share is not fully paid up if the company can demand more money from the investor. You don’t have to have exactly the same price per share for every investor: there can be slight fractional differences because of rounding. But rounding up to the penny is the safe approach and eliminates any question. One important point: you cannot have fractional shares for EIS purposes. Each investor must have a precise, whole number of shares, and you must know exactly what each investor paid for those shares.
Q&A: Convertible Loan Notes and EIS
Interviewer: What are the implications of convertible loan notes for future EIS rounds?
Philip Hare: Convertible loan notes and EIS don’t sit well together. You can do them, but you’ll be limited as to when they can convert or be repaid. There’s nothing wrong with having a CLN as long as you don’t breach the 30% rule: an investor can’t have more than a 30% interest in the company, including their loans.
The problem comes when the loan converts into shares. That’s treated as a repayment, and if it happens within your three-year restricted period, EIS relief is withdrawn to the value of the loan converted, even though no cash has changed hands. The resulting shares are not EIS shares, because they weren’t subscribed for cash. This means you’ve now got non-EIS shares in the company, which means you fail the independent investor requirement, and while you hold those shares, you can’t make any further EIS investment in the company.
It’s worth considering using an ASA instead of a CLN where possible, particularly where the purpose of the CLN is simply to price a future round.
Q&A: Investing in a Company as a Director
Interviewer: Can you invest, claim EIS, and then become a NED or executive director?
Philip Hare: Yes. This is colloquially known as the business angel exemption: the scheme is designed to attract talent as well as capital into early-stage companies, which is why directors are allowed to qualify while employees are not. You subscribe for your shares in the EIS company first, and then you can be appointed as director, either as a NED or as an executive director, and you can be paid, as long as that remuneration is reasonable for the services you provide. Subject to the 30% equity stake limit and the independent investor requirements, directors can qualify. You can also make further EIS investments in the company, assuming it’s still within the size limits, in the three years after your first EIS investment.
